In a recent article, Dane Bowler argued that investors should never pay full price for a REIT. He argues,
No REIT has acquisition abilities that are so special that an investor comes out ahead when overpaying for that REIT.
He goes on to point out that non-traded REITs generally have poor returns and suggests part of that is due to the structure requiring investors to pay more than full price. In my opinion, there are dozens of reasons why non-traded REITs are terrible deals for investors. I would never put a penny into one, no matter how good it looked.
He then goes on to focus on Realty Income (O), which is a great example of a REIT that chronically trades above NAV.
Realty Income is an excellent company that is likely on the higher end of execution skill, meaning it is one of those that can probably acquire a property with a present value that is 105% of purchase price (asset selection skill and cost synergies with existing portfolio). Thus, when O issues equity at its current price of $63.78, it can probably turn that capital into something worth a bit more than $63.78. It would seem this a good investment right?
Well, that is not how public REITs work. The investor buying shares at $63.78 isn’t just buying the new assets that will be purchased with the raised capital, but is also buying the existing assets. Realty Income has a NAV of $49.71, so investors are paying $63.78 for assets worth $49.71.
Thus, buying the freshly issued share is essentially buying 2 things.
1. The assets that will be acquired
2. The existing assets
Dane then offers the following table, showing what investors would be paying for in a theoretical $1b raise at $63.78.
NAV is a difficult number for retail investors to obtain. To get a current and frequently updated consensus NAV, you are probably going to pay for it. Alternatively, you could attempt to do your own NAV estimates, but even a well-done estimate could be filled with errors. You could guesstimate NAV by applying a single cap-rate to NOI, but small changes in assumptions will create very different results. At the very least, an accurate NAV estimate is a very time-consuming project. Does NAV really matter for the common stock?
Source: SNL Financial, Brave Eagle Wealth Management
This graph was provided in an article by Robert Ruggirello, CFA. As you can see, O has routinely traded at a premium to NAV over the last 10 years. The current 26% premium is elevated, but hardly the highest O has traded at.
The largest spike in the graph was early 2010, a time you would have definitely avoided investing in O if you were relying on NAV.
Buying in February 2010, when O was trading at over a 65% premium to NAV, would hardly have been a terrible decision. Since then, O has beaten the indexes, has been competitive with National Retail (NNN) and substantially beat Kimco (KIM).
While there are investments that have provided a better total return, if you were buying O back then, you probably feel pretty good about that decision today.
The Problem With NAV
The first problem with NAV is that it is incredibly hard to estimate and it is even harder to predict. Real estate, especially high-end commercial real estate, trades infrequently. It often sits on the market for many months, sometimes years.
NAV an educated guess at best, where even a relatively small assumption can make a rather large difference in the final value. When repeated across thousands of properties, a million here, a million there adds up. Coming up with a number that is +- 10% is not a small feat.
Then you have to account for leverage. A +-10% difference in NAV will have a larger than 10% impact on NAV per share. For example, Dane's estimate of NAV at $50.36 implies a gross property value of $21.697 billion. If that number is +- 10%, then O's properties are in the range of $19.527-23.867 billion. The amount of debt is fixed at $6.799 billion, so it is the equity value that will be impacted. The implied NAV per share would be $43.15-$57.86.
The difficulty of estimating NAV is further complicated by the reality that seller motivations play a huge role in the eventual sale price. A property being sold by a reluctant seller that has no particular reason to sell the property will sell for a much higher price than a property being sold by a seller that needs the money for some reason (say a maturing debt).
Buyers are not stupid, they are looking to get the best deal they can. Publicly traded REITs enter the negotiations with the significant handicap that the buyer can easily look at their financial statements and determine whether the REIT needs to sell the property or not. A REIT that is liquidating or has some significant need for the capital is going to get a much lower price than a REIT that doesn't care if the property sells at all. In any negotiation, the most powerful tool to have is the ability to simply say "no thanks" and walk away from the table.
Often what we see is that these REITs that are chronically trading at significant "discounts" to NAV reach the point of having significant asset sales or full liquidation, the NAV estimates drop like rocks and that value disappears. The vultures that come to pick the remains have absolutely no interest in paying anything close to what they calculate as market value. NAV is not set in stone, it is fungible and can change rapidly. Any NAV estimate really should be taken with a grain of salt.
Suppose you could accurately determine NAV, is that the value REITs should trade at?
More Than Just Property
Is there any chance in the world that O would entertain selling their entire portfolio for $22 billion? Not a chance. If you were handed $22 billion, could you build a replica portfolio of equal or higher quality? Maybe, but it would take you well over a decade (you can't deploy $22 billion in a year), a significant amount of skill and while you are deploying the capital property values would be varying significantly. Without raising additional capital, you would likely end up owning somewhat fewer properties since property values increase more often than not.
When you are buying shares in a REIT, you are not buying property. You are not directly taking on the benefits of owning property, nor are you directly taking on the risks.
With a REIT, you are buying a portfolio of properties that have been curated and developed over years. It is not something you could go replicate tomorrow, even if you had sufficient funds. You have a mix of seasoned properties with time-tested performance and newer acquisitions.
Past performance is not a guarantee of future success, but there is certainly value in being able to look at how a portfolio has performed in good times and in recessions. Seeing how a portfolio performed in good times and recessions can help assess potential risks.
Sum Of The Parts?
Taking the parts separately, if you were to buy any single O property, you are taking on a relatively large risk. For example, suppose you are are looking to invest around $3 million. You could buy a 7-Eleven with a 10-year lease at about a 5% cap-rate. Or, you could invest in O at a 4.11% yield. Which is a higher risk?
It does not take an experienced investor to identify that buying the one building is a much higher risk. Not only would the investment in 7-Eleven open you up to direct risks to the building, the tenant vacating, litigation, management expenses, renewal risk, etc. You can't just sell the building in a matter of minutes. Selling stock in a REIT is comparatively easy, you can sell all or part of your position on a whim, to cash in on a profit or to reduce your exposure if you are taking losses. With lower risk and far greater liquidity, it is entirely reasonable to expect that the investment in a REIT would be more expensive than investing in a single building.
REITs have the advantage of a very qualified team, significant diversification, and economies of scale. Due to those, any building in a well-run REIT has a lower risk than the same exact building on its own. Therefore, investment theory says that the well-run REIT should be more expensive than the buildings separately. Lower risk = more expensive/lower return requirement.
The question is not whether or not O should trade at a premium to NAV. Most can agree that O is a quality REIT and we should be able to agree that investing in O is a substantially lower risk than investing in any single one of their properties directly. It is arguable whether O should trade at a 5% or 50% premium to NAV, but there should be little dispute that it should trade at some kind of premium. It is, after all, a less risky and more liquid investment than the sum of its parts would be.
But A Discount Is Better, Isn't It?
A quality REIT should generally trade at a premium to NAV, but there are clearly many REITs that trade at a discount. Will a REIT trading at a substantial discount perform better? Maybe, maybe not.
When Mr. Market prices KIM at a discount to NAV, while at the same time pricing O at a substantial premium, what the market is saying is that KIM is riskier than O. The market is so uncertain about KIM that it believes KIM will see a declining value. Perhaps the market believes that NAV has already dropped.
The market is quite bearish on all malls and strip malls right now. The bearish sentiment is that America is over-retailed, that e-commerce is taking over and that malls and strip-malls are going to play a much smaller role in the future. If the bears are right, the values will drop and whatever KIM's NAV is today becomes irrelevant because nobody would buy the centers at those prices.
The million-dollar question is whether or not the bears are right. I believe that the bearish sentiment has become over-exaggerated. I believe that brick and mortar retail will continue to have a strong presence and that the worst of retailer bankruptcies are coming to an end. That is the basis of my investment in Washington Prime Group (WPG). However, it needs to be recognized that my bullish view is contrarian.
Contrarian investments can make a lot of money and dramatically outperform the market. They can also leave you feeling like a fool for ignoring what everyone else found so obvious and lead to a big loss.
NAV becomes a non-issue. If the bears are right, it is only a matter of time before NAV heads down the toilet. That "safety net" means absolutely nothing if the situation becomes so dire that KIM is throwing in the towel and liquidating.
When you see a REIT trading well below NAV, it is dangerous to think of NAV as a safety net. Instead, consider why it is trading so far below NAV. A healthy, quality REIT should be trading at a premium.
A discount is telling you the market sees problems and believes that the value is at risk. Those reasons might be REIT-specific, or they might represent bearish sentiment in an entire sector.
It is crucial for an investor to understand the reasons behind the discount. The market is saying that there is a significant level of risk. You might go on to conclude that the market is dead wrong, as it often is, or perhaps you conclude that it is a big risk but the price is cheap enough to accept it. Taking the position that the market is wrong can be very rewarding or it can be punishing.
So why should you pay full price for a REIT? Because REITs should trade at a premium. A REIT consistently trading at a premium to NAV for a significant amount of time is indicative of a quality REIT. If predictable, consistent and reliable income is high on your list of priorities, then quality REITs are something you might want to consider.
O almost certainly trades at a premium to any NAV calculation you care to do. O has traded at a premium to any NAV calculation you care to do more often than not for over 20 years. The only thing that matters to the common shareholder is whether O will continue to trade at a premium to NAV at whatever point they decide to exit the investment. As long as O continues to maintain their superior execution, they will continue to trade at a premium.
Does O have the upside potential that you might experience from KIM? No. What Mr. Market is saying is that O carries a lot less risk. I agree.
For the next 10 years, it is a safe bet that O is going to continue doing what it does. If you are looking for a REIT with safe and steady growing dividends, O has to be near the top of the list for your consideration.
Whether you pay a premium to invest in a lower risk quality REIT, or if you try to outsmart the market and invest at a discount in REITs the market believes are risky is a question of risk tolerance and personal preference.
Occasions like February/March of this year where you can buy a REIT like O at a discount to NAV are few and far between. It could easily be another decade before a similar opportunity occurs.
Having a strict rule of never paying above NAV for a REIT is going to put you into riskier REITs, and prevent you from enjoying the success of some really great quality REITs. Investing in riskier REITs can be a great strategy, but it is not one appropriate for all portfolios.
Sometimes, it is worth paying a premium to have quality.
Disclosure: I am/we are long O, WPG. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.